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Capital Structure Theories^281

extent of diversification etc. Financial distress occurs when the firm finds it difficult
to honour the obligations of creditors. The extreme form of financial distress is insolvency.
Insolvency could be very expensive. It involves legal costs. The firm may have to sell
its assets at ëdistressí prices. More important consideration is the inflexibility of raising
funds when needed if the firm has already used heavy amount of debt. Non-availability
of funds on acceptable terms could adversely affect the operating performance of the
firm.

Financial distress has many indirect costs as well. It has a great effect on the attitude
of management. The shareholders may like the management to invest in risky, marginal
projects so that debt holderís wealth is transferred. Management may also avoid
investment in profitable projects since, under an insolvency or financial distress, debt
holders are likely to benefit more from such investments. Creditors lose their patience
when a firm faces financial problems. They force the firm into liquidation to realise
their claims. A financially distressed firm also has a tendency to emphasise short-term
profitability at the cost of long-term sustainability and profitability.

Financial distress reduces the value of the firm. Thus, the value of a levered firm is
given as Value of levered firm = Value of unlevered firm + PV of tax shield - PV of
financial distress

Vt = vu + TD ñ PVFD ..(28)

Figure 11.4: Value of levered firm under corporate taxes and financial distress

Figure 11.4 shows the capital structure of the firm is determined as a result of the tax
benefits and the costs of financial distress. The present value of the interest tax shield
increases with borrowing but so does the present value of the costs of financial
distress. However, the costs of financial distress are quite insignificant with moderate
level of debt, and therefore, the value of the firm increases with debt. With more and
more debt, the costs of financial distress increases and therefore, the tax benefit

Vu

o Leverage Optimum ratio

Vl

Market

Value

Leverage

Leverage

Vu